In a recent debate in Forbes magazine in the context of the bankruptcy filing by the Monitor Group, which was formed by Michel Porter, many viewed ‘sustainable competitive advantage’ as a mirage in the current business environment. If a company can build sustainable competitive advantage, it continues to earn above average profit. According to Porter’s thesis, a company should choose either of the two generic strategies: cost leadership or differentiation. A company that is cost leader earns a higher margin because of its cost advantage over competitors. A company that pursues the differentiation strategy earns a premium for its products and thus earns above average profit. A company that gets stuck in the middle cannot earn above average profit and may find growth or even survival difficult. However, Porter does not suggest that a company that peruses differentiation strategy should not pay attention to cost management.
The view that the ‘sustainable competitive advantage’ is a mirage is true for most companies. In past companies that could build competitive advantage could maintain that for a long period. But in the fast changing business environment, it is difficult to maintain the same for long. There are companies that continue to earn their return higher than the average return primarily because they manage their intangible assets (not in accounting sense) and product and process innovation well. Although experts may differ, but Apple-Samsung rivalry shows that even a very strong company can face competition from a once unknown competitor. In the backdrop of this rivalry between Apple and Samsung, the survival and growth of other players depend largely on their ability to manage cost and innovation. Indian automobile industry presents another example how a leader can lose competitive advantage to other players.
In the above context it is imperative that every company should have an effective and efficient cost accounting system, which provides reliable information on operating costs and product cost and also provides support in strategic decision-making. Sophistication of the costing system depends on the complexity of the product, process and the business model.
Therefore, the board of directors should pay attention to the efficiency and effectiveness of the cost accounting system.
The government has ordered mandatory maintenance of cost accounting records by almost all companies that cross the threshold of specified turnover or net worth.
Most companies whose turnover exceeds Rs 100 crores or whose securities are listed in a stock exchange are required to get cost record audited by a practicing cost accountant.
For long the boards paid attention to accounting ratios and did not enquire into the adequacy and effectiveness of the cost accounting system. However, after the government initiative, some boards have started looking into the cost audit report. But many do not pay the deserved attention to cost audit report and view it as compliance of another unnecessary law framed by the government. It is true that financial statements capture the overall performance of a company. Therefore, if a company is able to manage cost effectively, the financial statements and accounting ratios will capture it. But financial statements do not tell the whole story of cost management.
For example, the financial statements and related audit report fails to mention whether the company has optimised the resource utilisation. Similarly the financial audit report does not give the assurance that the product and customer profitability presented before the board is correct. This is so because determination of product cost for inventory valuation under financial accounting rules is guided by the principle of accounting prudence as understood by financial accountants.
The principles applied to determine the product cost might deviate from cost accounting principles. Moreover, audit of the market/customer profitability estimated by the cost accounting system is outside the scope of financial audit. Therefore, financial audit is not a substitute for the cost audit.
When I interact with cost auditors, I get a gloomy picture of the adequacy of the cost accounting systems prevailing in different companies. This is not surprising because the average maturity level in the use of cost and management accounting principles, methods and tools in India is low. It is the responsibility of the board to ensure that the company adopts best cost and management accounting practices. This will be a move towards optimal utilisation of resources. It will also help the company to get appropriate cost and revenue information necessary to formulate and implement strategies.
The government has taken the right initiatives and now it is the responsibility of the boards of companies to take it forward.
The author is professor and head, School of Corporate Governance and Public Policy, Indian Institute of Corporate Affairs, Maneshar, and advisor (Advanced Studies), Institute of Cost Accountants of India
